6.6: Summary and Key Terms

Section Summaries

6.1 Calculate Predetermined Overhead and Total Cost under the Traditional Allocation Method

• Manufacturing overhead is estimated for the upcoming period.
• An activity base is selected to allocate overhead. This is traditionally direct labor hours, direct labor cost, or machine hours.
• A predetermined overhead rate is calculated by dividing the estimated overhead by the allocation base.
• Overhead is allocated to each product based on the estimated predetermined overhead rate and the number of units in the selected activity base.

6.2 Describe and Identify Cost Drivers

• Overhead costs are analyzed and grouped based on similar activity bases. A cost driver, such as inspections, machine setups, or order taking, is selected for each cost grouping.
• Analysis of cost drivers allows for better selection of true overhead cost drivers and more appropriate allocation of overhead.

6.3 Calculate Activity-Based Product Costs

• Costs can be traced to the unit level or batch level.
• There are five steps in the ABC process:
• identify activities needed for production
• assign a cost driver for each expense
• determine a predetermined overhead rate
• allocate overhead to each product

6.4 Compare and Contrast Traditional and Activity-Based Costing Systems

• Traditional allocation assigns overhead based on a single overhead rate, while ABC assigns overhead based on several cost pools and the activities that drive costs.
• Traditional allocation is optimal when the manufacturing process is labor driven and overhead increases based on traditional activity bases, such as direct labor hours, direct labor dollars, or machine hours.
• ABC costing is optimal when the manufacturing process is technology driven and overhead increases based on various activities that differ for each product.

6.5 Compare and Contrast Variable and Absorption Costing

• Absorption costing assigns all manufacturing costs to products, whereas variable costing only assigns variable costs to the products.
• Income statements from both methods can be reconciled by starting with the net income or loss using variable costing and adding the amount of fixed costs included in ending inventory and subtracting the fixed costs included in beginning inventory.
• Variable costing is not considered GAAP compliant but lends itself to cost-volume-profit analysis.

Key Terms

absorption costing
(also, full costing) system of accounting where all costs are treated as product costs regardless of whether they are variable or fixed
activity base
activity that has been considered to be a primary driver of overhead costs and for which, traditionally, direct labor hours or machine hours were used
activity-based costing
process of assigning overhead to products based on the cost driver for each activity cost pool
batch-level cost
one that is incurred when a group (or batch) of items is produced
common fixed costs
expenses that are shared among all divisions or production units and include such costs as the CEO salary and corporate headquarter costs
cost driver
activity that is the reason for the increase or decrease of another cost; examples include labor hours incurred, labor costs paid, amounts of materials used in production, units produced, or any other activity that has a cause-and-effect relationship with incurred costs
cost pool
accumulation of costs that are incurred during the production of the activities included in the activity cost pool
direct labor
labor directly related to the manufacturing of the product or the production of a service
direct materials
materials used in the manufacturing process that can be traced directly to the product
expense recognition principle
(also, matching principle) matches expenses with associated revenues in the period in which the revenues were generated
factory-level cost
one that is incurred when production occurs, such as production supervisor salary
indirect labor
labor not directly involved in the active conversion of materials into finished products or the provision of services
indirect materials
materials used in production but not efficiently traceable to a specific unit of production